Niche properties

Restructuring Infrastructure

This growing sector may be a road of opportunity for commercial real estate.

The infrastructure sector has become an increasingly popular investment class in recent years. While countries such as Australia, Canada, and the United Kingdom already have established infrastructure platforms to facilitate private capital flows, investing in U.S. infrastructure has been relatively limited in scope. However, with President Barack Obama’s intention to dedicate capital and resources to construct, maintain, and repair infrastructure assets, U.S. private investment opportunities are likely to become more abundant.

As these infrastructure plans come to fruition, commercial real estate professionals can remain on the front edge of this prolific movement. Knowledgeable industry experts can maximize opportunities to collaborate with government agencies on the construction and rollout of these projects as well as the ensuing private development.

Understanding Infrastructure in Today’s Market

Infrastructure systems are key elements in every community’s economic and social development. These systems serve the public well by helping to “sustain community life, safeguard the environment, protect community health, support the economy, and allow people and goods to move safely and efficiently,” according to the American Public Works Association’s Infrastructure Facts: Facts about America’s Public Infrastructure. Infrastructure investments typically are divided into five sectors: transportation, utilities, communications, social facilities, and specialty.

As evidenced by the numerous signs of distress that have materialized in recent years, the state of existing U.S. infrastructure is grim. Infrastructure failures have made national headlines in recent years, including Minneapolis’ Interstate 35W bridge collapse and New York City’s steam pipe explosion in 2007, New Orleans’ levee breaches in 2005, and the Northeast’s power grid blackout in 2003. Coupled with increasing usage and congestion across much of the U.S. infrastructure stock, these events underscore the need for improved maintenance and system upgrades.

Years of underinvestment and insufficient government funding combined with increasing population and economic growth have led to the deteriorated state of U.S. infrastructure. While government leaders have been reluctant to raise taxes or pursue alternative sources of revenue to repair and maintain the various infrastructure categories in the past, this is likely to change under President Obama’s administration. Repairs and maintenance will undoubtedly be costly — the American Society of Civil Engineers estimates $1.6 trillion in domestic infrastructure investment is required over a five-year period. Since public funding may not sufficiently cover current and future needs, private investment is viewed by both the public and private sectors as an increasingly viable option to fill the gap.

Investment Attributes

Institutional investors, including investment banks, private equity funds, infrastructure funds, insurance companies, and endowment funds, have shown increased interest in infrastructure during the past several years. While the nature of the various infrastructure categories can be quite diverse, the performance attributes of the underlying assets share many similarities, according to Private Equity International’s 2008 Private Equity Real Estate Special Report on Infrastructure.

  • Infrastructure investors often hold monopolistic market positions due to high initial fixed costs, resulting in substantial barriers to entry for potential competitors.
  • Stable and predictable cash flows are minimally affected by changes in the overall economy, thereby reducing volatility; this bond-like quality is comparable to a fixed-income investment.
  • Rent escalations are typically Consumer Price Index-linked, acting as a hedge against inflation.
  • The lifetime of infrastructure assets often spans decades, providing a long-term investment horizon that is appealing to many institutional investors, specifically pension funds, which need to match assets with liabilities.
  • Demand is somewhat inelastic, as infrastructure assets, with little or no risk of technological obsolescence, provide essential services to consumers.
  • A low correlation to equity and fixed-income securities benefits portfolio diversification.

Private equity investments in infrastructure typically are made in three ways, according to Ernst & Young’s Investing in Global Infrastructure 2007: An Emerging Asset Class. Privatization allows private investors to acquire public infrastructure assets or invest in state-owned companies. Public- private partnerships enable private companies to build and/or operate new infrastructure developments or existing assets under concession agreements with the government. Finally, private-to-private transactions facilitate the transfer of interests between two private parties. The public-private partnership model recently has been the method of choice for private investors looking to add infrastructure assets to their portfolios.

In the U.S., the transportation sector has experienced the greatest infrastructure investment activity. For instance, a joint venture between Australia’s Macquarie Infrastructure Group and Spain’s Cintra Concesiones de Infraestructuras de Transporte SA purchased concession rights to the revenue generated by the operations of two midwestern toll roads. Under the agreement, Macquarie/Cintra can raise tolls by a fixed percentage above the higher of either gross domestic product or CPI. In return, it is responsible for the toll roads’ upkeep and maintenance over the lifetime of the leases.

Another transaction highlights the largest private-sector investment in a U.S. new-construction toll road to date. In a $1.4 billion joint venture, domestic Fluor Enterprises and Australia’s Transurban Group agreed to finance, design, construct, operate, and maintain the new Capital Beltway high-occupancy toll lanes along a 14-mile stretch of Interstate 495 in northern Virginia. Fluor/Transurban will invest $350 million in private equity; the remainder of the project’s financing includes a $409 million capital contribution from Virginia as well as a $587 million loan under the federal government’s Transportation Infrastructure Finance and Innovation Act. After an anticipated five-year construction period, Fluor/Transurban will operate the new toll lanes for 75 years.

In addition to the above-mentioned transactions, public-private partnerships in 16 states have funded 24 transportation projects. Most recently, the Chicago City Council agreed to a $2.52 billion deal to lease Midway Airport for 99 years to Midway Investment and Development Corp., an investment group consisting of John Hancock Life Insurance Co., Citi Infrastructure Investors, and Canada’s YVR Airport Services Ltd., as part of the Federal Aviation Administration’s Airport Privatization Pilot Program (pending FAA final review). Looking forward, numerous other projects are currently in discussion, including the privatizations of the New Jersey and Pennsylvania turnpikes as well as the Tappan Zee Bridge along Interstate 87 in New York.

Return on Investment

What returns are institutional investors targeting for infrastructure investment? The answer to this question typically depends on the stage of the asset’s developmental or operational life cycle. Existing or mature infrastructure assets are similar to core real estate assets in that they have long lease terms and stable cash flows. Alternatively, investments in infrastructure development are comparable to opportunistic real estate on the risk/return spectrum. Falling between these two categories is a third subset that focuses on operational enhancements of existing assets. While investments in mature infrastructure assets can offer annualized returns in the middle to high single digits, investments in infrastructure development can produce annualized gains in the high teens or above in some cases, according to Infrastructure 2007: A Global Perspective, a joint publication of the Urban Land Institute and Ernst & Young.

From the fund perspective, core-plus infrastructure funds typically aim for 10 percent to 12 percent annualized returns while opportunistic funds aim for around 19 percent, according to Infrastructure 2008: A Competitive Advantage by Urban Land Institute and Ernst & Young. (Those returns are after typical management fees of 1.0 to 2.0 percent and performance fees of 10 percent to 20 percent.) No matter what the return expectations are, investors often are required to lock in a minimum investment of $10 million for 10 years; some funds even require a 25-year lock-in period.

Expanding Opportunities

Despite the risks associated with infrastructure as an investment class, the infrastructure investment universe is expanding, driven by global economic macro trends. These include legislation encouraging private participation in infrastructure, the extension of successful private equity and real estate funds into alternative investments, and the substitution of infrastructure for long-term bonds by pension funds.

Numerous global pension funds already have infrastructure allocations or have announced intentions to allocate funds to infrastructure, including the California Public Employees’ Retirement System, California State Teachers’ Retirement System, the Washington State Pension Plan, Alaska Permanent Fund Corp., and Oregon Public Employee Retirement System. In 2008, CalPERS adopted a new investment policy that allocated 3 percent of its assets, or $7.2 billion, to infrastructure. The Alaska Permanent Fund also committed $750 million to two infrastructure funds. Exposure to infrastructure of up to 10 percent generally is acceptable, according to the “The Role of U.S. Infrastructure in Investment Portfolios,” which appeared in the Journal of Real Estate Portfolio Management.

The growth of global infrastructure funds further illustrates this expansion. Between early 2006 and mid-2007, 72 new infrastructure funds were launched, raising an estimated $120 billion (with an additional $40 billion raised by existing funds during that period), according to Project Finance International’s Global Infrastructure Report 2007: The Rise of Infra Funds. Approximately half of these new funds followed the private equity model by raising capital from large institutional investors. The remaining funds were raised from other sources including insurance companies or pension funds investing their own capital, initial public offerings on major stock exchanges, or specialist teams within large commercial banks, asset management companies, or family offices. Fifty-six of the 72 funds focus on four main world regions — the U.S., Europe, the Middle East and northern Africa, and India — while 18 of the 20 largest funds focus primarily on the U.S. or European markets.

Additionally, based on global gross domestic product as well as trends in government and private spending on infrastructure, it is estimated that the potential for new private investment in infrastructure ranges from $240 billion to $360 billion annually worldwide. If the approximate $600 million in private-to-private utilities and telecom transactions from 2006 are included, the annual private infrastructure investment universe could approach $1 trillion globally, according to Ernst & Young.

The U.S., unlike other countries with developed infrastructure investment platforms, still is considered an emerging market, where recent infrastructure failures have resulted from a combination of increased infrastructure usage and lack of funding. Foreign companies with long-term track records have begun to take advantage of existing opportunities. The need for private funding to assist federal, state, and local governments in meeting the infrastructure demands of the expanding U.S. population base should continue to increase. As these funds fuel new infrastructure projects, commercial real estate professionals can look forward to opportunities to become involved in these critical developments

David J. Lynn and Matson Holbrook

David J. Lynn, Ph.D., is managing director of ING Clarion’s Research & Investment Strategy Group in New York. Contact him at (212) 883-2582 or Matson Holbrook is a former senior associate of ING Clarion’s Research & Investment Strategy Group in New York. Risks to ConsiderAlthough numerous benefits are associated with infrastructure investment, the sector also poses inherent risks. Proper evaluation of risk is particularly important when investing in a public-private partnership, especially in relation to the following key elements identified by Ernst & Young in Investing in Global Infrastructure 2007: An Emerging Asset Class.Long-term uncertainty: With concession contracts stretching up to 99 years, the accuracy of forecasting decreases as political, economic, and other future events deviate from initial assumptions.Revenue shortfalls: If public demand and willingness to pay do not meet expectations revenues could fall short of projections.Operational risk: It is essential that the private partner in a public-private partnership has the requisite competence, experience, resources, and skills to effectively operate the infrastructure asset.Political instability: In some cases, governments may not hold up their end of the contract for reasons that range from corruption to administration changes or internal political pressures.Environmental unknowns: Environmental reviews and approvals can increase project budgets while delaying start dates for new developments; significant capital expenditures may be incurred if unforeseen environmental hazards arise.Community acceptance: High usage fees for infrastructure assets may generate community opposition, especially if the operator’s profits are perceived to be excessive.Refinancing: As many infrastructure projects are leveraged in excess of 50 percent, refinancing at higher interest rates could increase risk exposure.


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